Process Costing

Production process helps to determine the best way for accounting for costs. If a large number of similar products pass through an identical set of processes, then each product within a product line passing through the three processes would have similar allocations of materials, labor and overhead. There would not be a need to accumulate costs by batches (job-order costing). Instead, costs would be accumulated by process.

Process costing works well whenever relatively homogeneous products pass through a series of processes and they receive similar amounts of manufacturing costs. Examples of this type of industry would be chemicals, tire manufacturers and large manufacturing plants.

Sequential Processing

There are different types of processes. Sequential processing requires that units pass through one process before they can be worked on in later processes. In each department, materials, labor and overhead may be added. After completing one process, the partially completed goods are transferred to the next department.

Parallel Processing

Parallel processing also requires two or more processes to produce a finished good. With parallel processing, partially completed units can be worked on simultaneously in different processes and then brought together in a final process for completion.

Cost Flow

The manufacturing cost flows for a process-costing system are generally the same as for a job-order costing system. Raw materials are purchased, and the cost of these materials flow into raw materials inventory. Raw materials, direct labor and overhead costs flow into a work-in-process (WIP) account. When goods are completed, the costs are transferred to the finished goods account. When they are sold, the costs are transferred to the cost of goods sold account.

Although the two process cost flows are generally similar, some differences do exist. In process costing, each product department has its own WIP account. As one department completes goods, they are transferred to the next department. Transferred-in costs are costs transferred from a prior process to a subsequent process. The subsequent processes treat these costs as a type of raw material cost.

Production Report

The product report is the document that summarizes the manufacturing activity of a process department for a given period of time. It contains information on costs transferred in from prior departments, as well as costs added in the department. It also provides information about the units processed in a department and the manufacturing costs associated with them. There are two main sections of this report. They are the unit information section and the cost information section.

The unit information section has two major subdivisions. They are the units to account for and the units accounted for. The cost information section has two major subdivisions as well. They are the costs to account for and the costs accounted for.

Computing unit cost is a key part of the production report. Unit cost is needed to compute the costs of goods transferred out of a department. It is also value ending work-in-process inventory. Conceptually, calculating unit cost is easy - just divide the total cost by the number of units produced. Calculating the ending WIP inventory is a bit more difficult. Defining the number of units produced can be difficult, given that some units produced during a period are complete while those in ending inventory are not. Also, the treatment of beginning and ending WIP inventories for the costs and work is questionable. There are different ways for handling these issues, as detailed below.

Equivalent Units of Production

Ending WIP, by definition, is not complete. How are these handled in calculating the output? For example, a department has a beginning WIP of 0 units. It completes production of 1,000 units during the month. It partially completes another 600 units (all at 25% completion), that are now the ending WIP. What is the output for the month for this department: 1,000 or 1,600? If you say 1,000, then you do not take into account the 600 in ending WIP. If you say 1,600, then you do not take into account that some of these are only partially completed.

The solution is equivalent units of output. Equivalent units of output is the total number of complete units that cold have been produced given the total manufacturing effort used during the period. In the example above, 600 were at 25% complete. 600 times 25% is 150. Therefore, the equivalent units of output in the example above is the 1,000 completed, plus 150 that could have been completed, for a total of 1,150.

If the total production costs for the month were $11,500, then the cost per unit is $10 ($11,500 divided by 1,150). The cost of goods transferred out is $10 per unit times completed units of 1,000, or $10,000. The cost of ending WIP is $10 per unit times 150 equivalent units, or $1,500.

Beginning WIP Inventory

Things get a little more complicated if there are units in the beginning WIP inventory. Work done on the beginning inventory costs represent prior period costs. So how should these costs figure into the computation of current period unit costs? There are two methods: Weighted Average Method and FIFO Method.

Weighted Average Method

The weighted average method combines beginning inventory costs and word one with current period costs and work to calculate this period's unit cost. Basically, the costs carried over from the previous period are counted as if they belong to the current period. The beginning inventory work and costs are pooled with current work and costs, and an average unit cost is computed and applied to both units transferred out and units remaining in Inventory.

FIFO

FIFO separates work and costs for the equivalent units in the beginning inventory from work and costs of the equivalent units produced during the current period. Only current work and costs are used to calculate this period's unit cost. This assumes that units from the beginning inventory are completed first and transferred out.

If the product costs do not change from period to period, or if there is no beginning WIP inventory, the FIFO and Weighted Average Methods will give the same results.

Weighted Average Costing

When using the weighted average costing, the production report has five basic steps that describe the general pattern of a process-costing production report.

Step 1: Physical Flow Analysis - The purpose of this step is to trace the physical units of production. Two amounts are computed. These are the units started and completed, and the units started.

Step 2: Calculation of equivalent units - This is computed by adding together the units completed and the units in EWIP times the fraction completed (600 units 25% would be 150). Any beginning inventory (BWIP) is included in the units completed. These units are treated as if they were started and completed in the current period.

Step 3: Computation of unit cost - The unit cost is calculated by taking the manufacturing costs and dividing by the equivalent units. Costs included prior period costs associated with BWIP, and current period manufacturing costs.

Step 4: Valuation of inventories (goods transferred out and EWIP) - To compute the cost of goods transferred out, multiply the unit cost computed in step 3 by the units completed found in step 1. To find the cost of EWIP, multiply the unit cost computed in step 3 by the equivalent units computed in step 2.

Step 5: Cost Reconciliation - The total manufacturing costs assigned to inventories are goods transferred out plus goods in EWIP. This is the total costs accounted for. Manufacturing costs to account for are BWIP plus costs incurred during the period. Cost reconciliation checks to see if the costs to account for are exactly assigned to inventories. The total costs assigned to goods transferred out and to EWIP must agree with the total costs in BWIP and the manufacturing costs incurred during the current period.

The major benefit of using the weighted average costing is the simplicity of it. The disadvantage is reduced accuracy in computing unit costs. If greater accuracy is desired, a company should use the FIFO method to determine unit costs.

Nonuniform Application of Manufacturing Inputs

Up to this point, we've assumed that WIP being 25% complete meant that 25% of materials, labor and overhead needed to complete the process have been used. Assuming uniform application of conversion costs (direct labor and overhead) is not unreasonable. Often though, material is not added uniformly. Instead, it is added at the beginning and end of the process. This leads to separate completion percentages for materials and conversion costs. Separate equivalent units, unit costs and category costs are computed for materials and conversion costs.

Multiple Departments

Some departments receive partially completed goods from prior departments. usual approach is to treat transferred-in goods as a separate material category. This means that the department receiving transferred-in goods would have three input categories: one for transferred-in materials, one for materials added and one for conversion costs. Cost of this material is the cost of the goods transferred out as computed in the prior department.